NU Online News Service

American International Group Inc. has shed some light on how a failed AIG derivatives unit and a rescue entity will handle differences between the value of collateral and the value of canceled derivatives transactions.

AIG, New York, has filed a copy of a shortfall agreement with the U.S. Securities and Exchange Commission.

The agreement was entered into Nov. 25, 2008, and amended Dec. 18, 2008, according to the copy posted on the SEC Web site.

The Federal Reserve Bank of New York worked with AIG to set up Maiden Lane III.

The entity is using a combination of Fed money and AIG money to acquire “multi-sector collateralized debt obligations” linked to credit default swaps written by AIG’s shuttered AIG Financial Products Corp. derivatives unit.

Once the entity acquires the CDOs, credit default swaps and similar instruments that insure the CDOs are canceled, in an effort to avert the possibility that the failure of a CDO could trigger a self-sustaining cycle of credit default swap failures at many different financial institutions.

On Oct. 31, 2008, AIG Financial Products was party to derivative transactions with a total notional value of about $54 billion, according to the text of the shortfall agreement.

AIG Financial Products has delivered collateral to the derivatives counterparties to back the transactions.

In many cases, the value of the related CDO issue is less than the derivative transaction value, according to the shortfall agreement.

If the value of the collateral posted is less than the value of the terminated derivatives transactions, then AIG Financial Products must cover the cost of the shortfall, according to the agreement.

If the value of the collateral posted is greater than the value of the terminated transactions, then Maiden Lane III must pay an adjustment amount to AIG Financial Products, according to the agreement.

AIG Financial Products promises in the agreement not to try to join in any bankruptcy proceedings or similar proceedings against Maiden Lane III in connection with obligations relating to the agreement.

The agreement includes a confidential schedule that lists the counterparties to the derivative transactions involved in the transaction terminations.

A copy of the AIG Financial Products-Maiden Lane III shortfall agreement is available here.